Real estate

Rising interest rates dampen commercial real estate activity

The air comes out of the balloon. Or, as John Mayer might put it, gravity is working against the commercial real estate industry. Price growth is weakening across all property types and becoming more pronounced as each month’s data arrives.

What is behind this “gravity” that works against the industry? Commercial real estate is one of the most capital intensive businesses, and today capital is more expensive. Yields on Treasury bills have increased by 3.70%, 2.80% and 2.50% respectively for one-, five- and ten-year Treasury bills over the past eight months. Spreads rose about 0.25% to 0.45% over the same period, according to the John B. Levy & Co. Commercial Mortgage Survey. interest from around 3.35% to 3.50% in March to 5.80% to 6.25% today.

To put things in perspective, with everything else being the same, this rate increase reduces debt proceeds by more than 25% in eight months for a typical transaction. So, while there are plenty of spot buyers, this abrupt shift in the debt market puts leveraged buyers out.

People also read…

Anecdotally, the industry is seeing a decline measured by the time it takes to complete an assessment. Where it used to take three to four weeks, reviewers are less busy now and the timeframe has been reduced to two to three weeks. Another indication is broken chords. Lenders reported being called back for deals where they were previously uncompetitive weeks after the potential deal was removed from their pipeline report.

Recent investment sales data from MSCI (formerly Real Capital Analytics) indicated that year-over-year trading volume fell 41% in August, but the data indicates that trading volume is up year-to-date compared to the same period in 2021. Similarly, in the debt world, commercial mortgage-backed securities volume year-to-date is down 21 % in the United States compared to the same period in 2021. It is expected to “slow to a trickle” through the end of 2022, according to a recent Commercial Mortgage Alert.

In addition to the damage to date, the Federal Open Market Committee is meeting this week and again in December. It is widely expected to push the short-term rate up from 1.25% to 1.50% by the end of the year.

It’s not like we haven’t had such high rates in the past. If you go back to before the Great Recession, mortgage rates fluctuated between 5% and 6% for most of 2006 and 2007, very active years in the commercial real estate world. The pain comes from the speed at which the upside shifts have occurred and the Federal Reserve’s continued fight against inflation.

For now, in the Richmond real estate market, cap rates are holding steady or trending lower, according to data from commercial real estate research and analysis firm CoStar Group. While office and retail cap rates are flattening, overall apartment and industrial cap rates are trending lower. The question is, how long can this hold up when interest rates are still rising?

John B. Levy & Co. partner and investment banker Andrew Little can be reached at [email protected]